(Republished from “A View from the Trenches”, October 9th, 2012)
Please, click here to read this article in pdf format:Â October 8 2012
As we pointed in our last letter, we have lately noticed that there is an ongoing debate on whether (or not) the world can again embrace the gold standard. We join the debate today, with an historical as well as technical perspective. Todayâ€™s letter will deal with the historic part of the discussion. In the process, you will see that we side with some popular ideas, while we challenge others.
The gold standard will be the last option: If adopted, it will be out of necessity and in desperation
We are not historians. In our limited knowledge, we note however that historically, the experiment of adopting a gold standard â€“or a currency board system- was usually preceded by extremely trying moments, including the loss by a government of its legal tender amidst hyperinflation.
The change to a commodity standard has often been then out of necessity. We witnessed one of these episodes first-hand, in Argentina, back in 1991. The local currency was decreed convertible into US dollars (i.e. a currency board) at a rate of 10,000 to 1, and assigned a new name: peso argentino.Â The method with which this was carried out challenges the current speculation regarding gold, according to which gold bullion would be confiscated, in order to provide reserves to a central bank daring to return to the gold standard. In Argentina, US dollars were not confiscated to back the peso. There was no need do that. On the same grounds, we donâ€™t think gold would need to be confiscated, although one must never, ever underestimate stupidity.
How did Argentina implement its convertible system? The central bank adopted two relevant measures: The first was to change its charter to prohibit holding government debt. The second measure was toÂ commit to sell unlimited dollars at the established pegÂ of 10,000Â to 1. Of course, the first measure was later violated. But thatâ€™s a discussion for another day.Â What it matters is that they committed to sell the asset backing their liability (i.e. the peso), but not to buy it.Â From then on, nobody dared to challenge the central bank until 1994-5, when the Mexican peso was devalued. And even then, the system passed the test.
The 10,000:1 peg was based simply on the fact that that was back then, the amount of local currency per each US dollar in reserves.Â It is very conceivable that, under an inflationary spiral, the US government may proceed similarly. If at that time there are x thousand US dollars per ounce of gold at the US Treasury, a peg may be established to reflect that ratio. And just like it occurred in Argentina, we would not expect the Fed to be challenged.
From those years, we also remember this:Â When the peg was set at 10,000:1, there were many who thought that the US dollar was still underpriced. However, think about this: Why would the market have paid for your US dollars more than 10,000 (Australes), when the market knew that, in the absence of a bid, all you could get from the central bank was going to be 10,000?Â We can very much foresee a similar situation where, the market price of gold collapses from its peak to the established peg, leaving painful losses.
A gold standard with reserve requirements below 100% will not work
There were many flaws with the currency board rehearsed by Argentina. But remember: It was established out of necessity, without time to plan. Just like the European Union is handling its problems today and just like the US will handle theirs tomorrowâ€¦
The most important flaw, in our opinion, was that it left the central bank in its role as lender of last resort, while at the same time it allowed banks to have reserve requirements below 100% (about 30%). Therefore, the credit multiplier was after all still very much in place. The fact that the central bank would later invest some of its US dollars in USD denominated (Argentine) government debt was not critical. Nor was it relevant that banks were coerced to buy government bonds with deposits (like they are in the Euro zone today). The crux of the matter was that as both of these things happened, the central bank wasâ€¦.well, the central bank! The lender of last resort! Had the central bank been only a note bank for legal tender, without any other responsibilities, the Argentine default of 2001 would have not triggered a systemic crisis. But it was not a note bank, it was the lender of last resort and the crisis became systemicâ€¦.just like we fear will happen, if the US implements a gold standard in a rush. Why do we fear this? Because if all plays out that way, the world will lose faith in the gold standard for the wrong reasons.
The Bank of Amsterdam and the Industrial Revolution of the XIX century
Popular wisdom has the birth of the industrial revolution in XIX century England. Some, with a technological emphasis, are willing to concede that already by the time of the French Revolution, the years of the Enlightenment, the seeds had been planted for the technical developments that would come later. The Napoleonic Wars are thus regarded by these people as an interruption, a hurdle, in the race by the West to conquer the world. Only a few point out and even admit that, as a coincidence, during that industrial revolution and particularly at the end of the XIX century, gold was money. But this is treated as a mere coincidence. There are others too, who are convinced that if gold had not been money, if Great Britain had not adopted the gold standard, the speed of the industrial revolution would have been even more impressive.
None of this, in our opinion, could be farther from the truth. We are not historians and we expect many to challenge our comments today, but we offer this view:Â The industrial revolution did not begin in England, but in what was then known as the Low countries, and was enabled in a decisive way by a gold standard with 100% reserve requirement established by the city of Amsterdam.Â There are two parts in this conjecture: The first one is that the industrialization began in the Low Countries. We side here withÂ Henri PirenneÂ and suggest that this birth was brewed by the system ofÂ HansastÃ¤dte, and in particular, in Brugge, where very early, for instance, the Medici opened a branch.
If our view is correct, the counterfactual argument therefore lies in proving that the development from that stage into the XIX century would have been possible, had the city of Amsterdam not established theÂ Bank of AmsterdamÂ (Amsterdamsche Wisselbank). We leave to our readers to do their own research on this speculation.
The Bank of Amsterdam took upon itself to accept bullion in deposit, issue notes in exchange for circulation and charge (yes, you read well, charge!) depositors for their bullion as well as a â€œliquidityâ€ fee for making such deposits liquid, thanks to the issuance of their (i.e. the bankâ€™s) notes.
In his book, â€œThe Ascent of Moneyâ€, Neil Ferguson makes a few interesting observations about this period:
Inflation (donâ€™t ask us how Mr. Ferguson measured it, but this is what we read) fell from 2% p.a. between 1550 and 1608 to 90bps pa between 1609 and 1658 and 10bps p.a. between 1659 to 1779! This represents no less than 229 years of price stability! With the low life expectancy of those years, this period would have easily encompassed 9 generations. Can you even begin to picture that? In todayâ€™s terms, this would mean that the currency held by an American living back at the time George Washington was president would have kept its purchasing power to this day, had a similar financial stability taken place!
In 1602, the Vereenigde Nederlansche Geoctroyeerde Oostindische Compagnie (East India Co.) had its IPO. Between 1602 and 1733 its share price rose from par (100) to 786, in spite of the fact that between 1652 and 1688 they had to face, with violence, the attacks of Britain at their trading posts. By 1650, with the dividend payments the company made, buy-and-hold IPO holders would have earned an annual compounded rate of return of 27%. Given how popular this IPO was, Â this context of financial stability brought about perhaps the most widespread capitalization ever witnessed by a nation.
This stability was based on a 100% reserve requirement. With it, when the East India Co. began to fall, its decadence was gradual: It took 60 years and by 1794, it was still worth 120 or 20% above par, in terms of a currency that had preserved its value all along! In other words, it was still 20% up in real terms. In real terms also, by 1690, the company was bringing back to the harbours of the Netherlands about 156 ships per year, all loaded up with consumption goods for the enjoyment of the Dutch people. In other words, on average, one ship every two days was being loaded up in a trading post in Asia. There were no cranes, no trains, no telecommunications.
In summary, the Argentine case and the Dutch Golden Age suggest that the elimination of the credit multiplier (i.e. extinction of shadow banking) is more important than the asset backing a currency. The Argentine case shows what can go wrong, when a currency is asset backed, but reserve requirements are allowed below 100%. The Dutch case shows what can go well, when a currency is commodity-backed and reserve requirements are held at 100%.Â Bear in mind that the notes of the Bank of Amsterdam were not enforced upon the people, they were not legal tender.
Unlike todayâ€™s policy makers, the Dutch of the XVII century had the luxury of planning their system, based on the collective wisdom of their merchant class. Does anybody think that the Dutch Golden Age would have taken place had the Bank of Amsterdam not existed? Does anybody think thatEnglandwould have been able to accumulate capital from its natural resources (wool, meat), without the demand of the early industries of Brugge, Liege, Amsterdam or Antwerp? We donâ€™t!
Therefore, the question that lies before us is: How can we replicate the success of the Bank of Amsterdam, in todayâ€™s context? How can we not fall prey to necessity, just likeArgentinafell back in 1991? That remains the subject for our next article.